Is Startup Investing Killing the Stock Markets?

Starting up to raise money is the new thing. Up until a decade back, people tried to raise money to start-up. What’s changed?

Two main reasons why startup investing is at an all time high:

[1]Returns Generated: Startups which succeeded in past delivered unbelievable returns (think about the value created by Facebook and Zomato);

[2]Lack of avenues for investing: stocks, real estate and gold are all down.

WHAT KIND OF RETURN SHOULD YOU EXPECT FROM STARTUP INVESTING

Investing in startups has become highly rewarding. Venture capital and private equity firms are forever in hunt for passionate entrepreneurs in need of capital to hit the market with their ideas. In return for their capital, these players take a large stake in the business, either until you generate enough profit to buy them out, or permanently.

That said, startups as investment opportunities are suitable mainly for those who have high risk appetite and are able to invest in multiple ventures. This is because, the success rate of startups is extremely low (think less than 10% of ventures which get funded).

Investors who wish to partner with larger private equity firms or who want to form their own business of funding startups should be ready for this reality and expect to Make At Least 5 – 10 Times return in each venture and ALSO be prepared that 9 Out of 10 Ventures Could Fail. Typically, private equity and venture capital firms work on law of averages, i.e. even if one or two ventures turn profitable, they more than cover the losses incurred in other ventures.

Further, these firms not only put their capital in the business but also mentor and help in scaling up the business and often have dedicated teams for marketing and promotional activities. To the point that if you have an innovative idea, it would be better to involve a seasoned funding partner than put your own capital.

LACK OF AVENUES

Capital flows towards higher returns.

Stocks

Unfortunately stocks is not where capital is finding any returns whatsoever, at least for the last 52 weeks. We have had four consecutive quarters of declining corporate earnings.

Ideally, in a situation like this, I would be the first one to raise my hand and say – “Great time to invest, there’s bad news all around and so the markets are available cheap”. What’s different this time however is that such has been the case for much too long.

Add to this the fact that during the last few years, businesses have taken on huge debts hence pushing their interest coverage lower. In the current market scenario, there appears little merit in stock investing, particularly for short to medium term. Not only are earnings declining, valuations are not improving either.

Rest assured, a few quarters with improved earnings and this could change very quickly. For now however, investors, big and small; HNIs and institutions are all looking towards the big risk-reward arena of startup investing.

A Business Paradox

While I have written extensively about stocks which you should be buying, I have long maintained the view that many listed stocks will not generate any return in future, no matter how long your time horizon. The reason is simple, some businesses have permanently been replaced by more efficient alternatives but those stocks still remain listed on the bourses. Take the example of MTNL. In today’s fast changing world where companies like Airtel and Vodafone are struggling to scale up their wireless technologies, how can fixed line phones compete? Of course if tomorrow MTNL (or any other listed company) finds a superior mode of communication, it may outperform all else but that has nothing to do with the merits of investing in the business as it stands today.

The need is to get more innovative, modern day businesses on the stock exchanges. There are service apps for cabs, food deliveries and travel. Doctors and lawyers are trying to build apps to reach millions of litigants and patients. These businesses need capital to scale up back-end operations and can generate far higher returns than some of the old and traditionally listed businesses.

Real Estate

I get approached by loads of real estate intermediaries whose job is to sell houses on behalf of builders. Their commissions largely depend on selling at or above builder’s desired price. I also meet a lot of seasoned old businessmen who traditionally invested in a lot of real estate. Most of them now want to sell some of their real estate. The trouble is that the only people with buying capacity are well paid professionals and new-age businessmen, neither of who will pay anything other than their accounted and tax paid white money.

With the government tightening the screws on black money and with tax procedures becoming more transparent (thanks to online filing), real estate is no longer a safe haven for unaccounted money. On the contrary, real estate has become a market where people have started believing way too much in the “Greater Fools Theory**”. This is always a very worrying sign.

In my opinion if someone tells you to “hold on to your investments in real estate for another year or two and you will be able to sell it at a higher price”, stop taking his calls. Sell now if you can; I am mostly right about predicting future prices for assets. Don’t live with the belief that real estate prices never fall because land is limited and people are unlimited. There is nothing more stupid than that.

** Greater Fools Theory: A theory which is premised on the belief that the price of anything is what somebody else is willing to pay for it. The fair or utilitarian value of the underlying asset is not as important as irrationality and absurdity of the market. Those who believe in this theory buy something based purely on one single belief – SOMEBODY ELSE WILL PAY ME HIGHER FOR IT.

Gold

I have written extensively about investing in gold. Simply put my view is – Why invest in a metal with absolutely no productivity or sovereign backing. Remember: money printing is not dependent upon gold reserves, a view which many people wrongly hold.

SO IS STARTUP INVESTING REALLY KILLING THE STOCK MARKETS?

Short answer – No.

Today’s startups will go on to be part of stocks listed on the stock exchanges. It is not ‘either-or’ between stock investing and startup investing. These opportunities are mutually exclusive with only one thing in common – in both cases capital weighs the risk-reward promise before getting deployed.

Last updated: 10th September, 2015

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Rajat Sharma is a well known stock market analyst and commentator. He has covered Indian markets for over a decade and is regarded for consistently identifying early stage investment opportunities. Attorney by qualification, Rajat has done extensive work for improving corporate governance and disclosure standards.